Emerging Market Debt : Has the bad news been largely priced in?

Emerging Market (EM) economies have seen a sharp de-synchronization this year. There are three key reasons to explain the differentiation of EM asset performance year-to-date:

1. Trade tensions have fueled further uncertainty and some EM countries are more at risk than the others
2. Rising risk aversion has shifted investor appetite away from countries with the weakest fundamentals, such as Argentina, South Africa and Turkey. The main criteria that the market has been focusing on are “twin deficit” (current account and public deficit) and the massive debt issued in hard currencies (USD and EUR). This has led to a sharp fall in the respective currencies, and in turn, reinforced the vulnerability of “the weakest link”. However, we still maintain the view that the risk of contagion from “the weakest link” is relatively low.
3. Political risks such as the Brazil elections, and the geopolitical tensions in the Middle East

Signs of Improving Outlook for Emerging Markets

Several EM countries, which have been the key concerns in recent months, have been making progress in terms of policy changes.

• Mexico - We have been less negative on the country since early last month as uncertainties from both the North American Free Trade Agreement and macro policies from the new administration have diminished
• Turkey – We have turned less negative on Turkey since early this month, The much larger-than-expected rate hike in September by Turkey’s central bank has since stabilized the local currency. Although the political and economic environment remains challenging in Turkey, its distressed valuation could provide a floor.
• Brazil – October is the month of the country’s general elections. There could be a potential change in our currently negative view on Brazil depending on the outcome of the elections. 
• Argentina – The International Monetary Fund raised credit line to USD 57 bn for Argentina in September. The sharp fall in peso has been stabilized.
• China – Beijing has changed its policy stance and has been stepping up its easing efforts in recent months.  

There are still some idiosyncratic risks for some specific EM countries, but a lot of negative news is already priced in. Given the deep corrections in 1H 2018, yield-to-worst of EM (USD) bonds (EMBI Global Diversified Index) has gone up significantly from 5.2% in January this year to 6.6% at present, the peak levels last seen in January 2016.    

With the current heavy positioning in long US dollar, which we believe is also fundamentally overvalued, we expect to see the greenback to weaken in coming quarters. A weaker dollar tends to benefit EM assets.